The Production Possibilities Frontier Illustrates the Law of Increasing Opportunity Cost - The Economic Lowdown Video Series, Episode 8, Segment 3

The PPF Illustrates the Law of Increasing Opportunity Cost | St. Louis Fed

Have you been to a frontier lately? Whether you realize it or not, the economy has a frontier—it has an outer limit of economic production. In the eighth episode of the Economic Lowdown Video Series, economic education specialist Scott Wolla explains how the production possibilities frontier (PPF) illustrates some very important economic concepts.

The final segment of The Production Possibilities Frontier uses the production possibilities frontier to demonstrate how, in the real world, opportunity cost increases as production increases. This is a difficult concept made simple using the PPF.

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Transcript:

Below is the full transcript of this video presentation. It has not been edited for readability, and there may be slight differences between the text and the video.

Our final lesson focuses on the shape of the frontier line. Up to this point we've graphed the PPF as a straight line. However, a straight line doesn't best reflect how the real economy uses resources to produce goods. For this reason, the frontier is usually drawn as a curved line that is concave to the origin. This curved line illustrates our fifth and final lesson.

Lesson 5: The law of increasing opportunity cost: As you increase the production of one good, the opportunity cost to produce the additional good will increase.

First, remember that opportunity cost is the value of the next-best alternative when a decision is made; it's what is given up.

So let's compare straight and curved frontier lines to better understand what is more likely to happen when production changes.

Here's the straight frontier line again.

It shows that Econ Isle can produce a maximum of 12 gadgets and 6 widgets or any other combination along the line.

At this point, Econ Isle can produce 12 gadgets and 0 widgets. This point shows widget production increased by 2, and this by 2 more, and this by 2 more, indicating all widgets and no gadgets.

So along the straight line, each time Econ Isle increases widget production by 2, it loses the opportunity to produce 4 gadgets. This straight frontier line indicates a constant opportunity cost.

In reality, however, opportunity cost doesn't remain constant. As the law says, as you increase the production of one good, the opportunity cost to produce the additional good increases.

If Econ Isle transitions from widget production to gadget production, it must give up an increasing number of widgets to produce the same number of gadgets. In other words, the more gadgets Econ Isle decides to produce, the greater its opportunity cost in terms of widgets.

If Econ Isle's production moved in the opposite direction, from all gadgets to all widgets, the law would still hold: As you increase the production of one good, the opportunity cost to produce the additional good increases.

Why does this happen? Well, some resources are better suited for some tasks than others. For example, many Econ Isle workers are likely very productive gadget makers. In the transition to widget production, workers would likely need training and time to develop the skills required to be as productive at making widgets as making gadgets. As the economy transitions from gadgets to widgets, the gadget workers best suited to widget production would transition first, then the workers less suited, and finally the workers not at all well suited to widget production.

Here's where the curved frontier line comes in. It shows that opportunity cost varies along the frontier.

Let's increase widget production in increments of 2 again until only widgets and no gadgets are produced. But this time we'll consider opportunity cost that varies along the frontier.

This point remains the same. At this point, Econ Isle can produce 12 units of gadgets and 0 widgets.

Here's widget production increased by 2. At this point, Econ Isle can produce 10 gadgets and 2 widgets. It loses the opportunity to produce 2 gadgets. In other words, the opportunity cost of producing 2 widgets is 2 gadgets.

Here's widget production increased by another 2. At this point, if Econ Isle produces 6 gadgets, it can produce only 4 widgets, so it loses the opportunity to produce 4 gadgets. In other words, the opportunity cost of producing 2 widgets is now 4 gadgets.

Finally, increasing by another 2, Econ Isle can produce 0 gadgets and 6 widgets. It loses the opportunity to produce 6 gadgets. In other words, the opportunity cost of producing 2 widgets is now 6 gadgets.

Although the production possibilities frontier—the PPF—is a simple economic model, it's a great tool for illustrating some very important economic lessons: The frontier line illustrates scarcity—because it shows the limits of how much can be produced with the given resources. Any time you move from one point to another on the line, opportunity cost is revealed—that is, what you must give up to gain something else. Points within the frontier indicate resources that are underemployed. In turn, movement from a point of underemployment toward the frontier indicates economic expansion. When the frontier line itself moves, economic growth is under way. And finally, the curved line of the frontier illustrates the law of increasing opportunity cost meaning that an increase in the production of one good brings about increasing losses of the other good because resources are not suited for all tasks. 

I hope you have enjoyed your journey to the frontier and learned some valuable lessons about economics along the way.

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Audience:   Consumers, College, High School, Middle School
Language:   English
Subjects:   AP, Economics
Resource Types:   Video, Multimedia
Concepts:   Factors of Production/Productive Resources, Production Possibilities Frontier, Opportunity Cost, Scarcity, Productivity
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